Prudent investors know there’s no free lunch

By Zachary Krajacic

“The first rule of finance is that there is no free lunch,” said my investments professor emphatically. More than 20 years later, those words still ring true, louder than ever. Yet what do we want? Not only a free lunch, but a free breakfast and free dinner as well, appetizers included. Oh, and don’t forget dessert.

Like the laws of physics, the laws of economics and finance are not malleable. Who in their right mind would think they could leap off the top of a mountain and defy the law of gravity? Yet some people, such as politicians and central bankers, think they can outwit the inviolable rules of finance and economics, and many consumers think credit equates to free money.

But as a prudent investor, you know better. While the rest of the world may be living as though they are in one of those funhouses where mirrors distort reality, you know that neither you – nor anyone else – can defy the laws of economics and finance. As someone who has studied the menu, you know that when it comes to investing, there is no free lunch.

Thus, never before have the basics of investing – diversification and long-term growth strategy – been more relevant and more important. They are an investor’s best friend, especially during these precarious times in which the market does not reflect economic reality. The Fed’s monetary injections into the bloodstream of an ailing economy have produced low interest rates, which has boosted riskier investments, such as stocks. This has made the market appear healthy and robust, but like the housing market several years ago, it is on artificial life support.

As a prudent investor, you know your investment strategy must take into account a potential bubble that may be on the verge of rupturing. A conservative and cautious approach must be employed until government gets its house in order, the economy improves and businesses start hiring. Maybe then you can begin to take risks again. But until that happens, a prudent and disciplined approach will help protect your assets by buffeting the winds of a financial storm.

Focus on generating solid returns without incurring significant risk. Consider investing in an index fund that tracks the S&P 500. Even if the economy takes a downturn, your losses would be far less than if you were to invest in less-diversified and more-risky stocks or mutual funds focused on maximizing potential returns. In the event of heavy losses, it is possible that you would not be able to recover them.

What’s more, safer investments often post better returns than riskier ones, especially over a long period of time. For more than 10 years, I owned three mutual funds through three different, equally reputable investment firms. My least risky fund was an S&P Index Fund, my moderately risky fund was a Growth Index fund, and the most risky fund was an Aggressive Growth fund.

Surprisingly, the performance of each of the funds was remarkably consistent. Both in good times and in bad, the S&P fund was always the best-performing fund. When the market was down, it lost less value than the other two; when the market improved, it increased in value more than the others. The Growth Index fund was always slightly behind the S&P Fund. The Aggressive Growth Fund lost much of its value after the market tanked at the dawn of the new millennium, then consistently lagged behind the others by a considerable margin, and rarely showed much improvement. Even when the market surged, it barely moved and never regained its initial value, while the two safer funds both produced capital gains.

Given the geopolitical events in the world, widespread turmoil and volatility, and economic instability both at home and abroad, your focus right now should be on preserving capital and cash flow. Diversify your investments. Put your cash in traditional, solid companies and industries that have good management, deliver a necessary and quality product and treat their employees well. Invest in companies that provide basic goods and services that people will always need, such as food, clothing and utilities. OK, perhaps some shares of Apple
/quotes/zigman/68270/quotes/nls/aaplAAPL won’t hurt.

Solid financial frameworks and worldwide stability may re-emerge eventually and make the market more conducive to risk-taking. But until that time comes, it is important to have a long-term outlook. I know this sounds old school, but look where the new school has gotten us. Some principles are time tested – it is wise to follow them.

An investor’s greatest virtue is not greed, but patience. The people who think their lunches are free will have to pay for them eventually. That’s when you, a prudent investor, will have your fill.

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